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Daily Archives: June 1, 2015

From time to time, (non-economist) friends of mine with send me an article by an economist criticizing the field of economics. Some are insightful; some are not. A very close friend most recently sent me article via the New York Times (see the article here) by the famed University of Chicago economist Richard Thaler. And unsurprisingly, like most of these articles I am informed of, the article was written by one of those that espouse a school of thought known as Behavioral Economics: a hybrid field melding together economics and psychology. At its root, behavioral economists aim not at criticizing economic theory per se (although some do), but put more focus on questioning the assumptions placed upon many of the more primordial economic models.

So, what’s the problem? Questioning simplifying assumptions is a good thing, right? Yes and no. While not on par with Marxist/Heterodox economic theory, the field itself has been very controversial since its inception. From an academic point of view, there was — and still is — some suspicion that behavioral economics was developed so that psychologist could publish in economic journals and vise-versa. On a more concrete plane (and a lot less gossipy), others have more valid concerns. Chief among them is the critique that economic models are based upon unrealistic assumptions and, hence, wrong . . . or, at the very least, useless in the proverbial “real world”. You can see how someone who has dedicated his/her academic and professional career to theoretical economics could take this personally.

Are they correct? Again: yes and no. Before I continue, I should mention here a small disclaimer. I am a theorist (well, a “game theorist” if I want to sound interesting at weddings and iftars); that is, my research is generally based around formulating mathematical models of strategic human behavior. Game theorists and behavioral economists tend to be on opposite sides of the hypothetical battlefield. We are not at archenemy status a la Sherlock and Moriarty, but let us just say that debates at conferences have been known to get very (VERY) heated. My article is not meant to validate or discredit the study of behavioral economics. Instead, I wanted to introduce to the “economic laity” a bit of background of the debate . . . but it should be noted that I write from a biased position.

Economics, being the study of human decision-making, is not unique in the problems it approaches to solve. Many topics within the field of economics can also be found throughout both the liberal arts and business studies. What makes the study of economics so special is not the questions it seeks to answer, but how we approach solving such questions. This is commonly known as economic reasoning. Think of it as a metaphorical CSI toolbox of strategies and assumptions that each economist brings with him/her to the crime scene.

Assumptions? Aren’t assumptions bad? We have probably all heard the classic adage: “When you assume, you make an ass out of you and me”. This is true in most social situations in regards to preconceived prejudices. Yet science is a bit of a different story.

All sciences, schools of thought, fields and models have assumptions; it is a necessary fact of any scientific field, be it a social science or a physical science. The results of any model are limited by its preset assumptions and/or controls – this is known as the robustness of a model’s results. The goal of any researcher is to create a model with assumptions and then, slowly, begin to take away these assumptions one by one. This could take years, decades or entire careers. It is not easy.

Therefore, classical economic theory begins with an assumption: economic agents (economics jargon for any one or thing making a decision with resource constraints) act rationally. By acting rationally, we mean to say that economic agents are seeking to maximize their happiness and minimize their suffering. The inclusion of the word “seek” here is very important. Economists are aware that people make mistakes, even when they act with perfect rationality. To be explicitly clear, this assumption is NOT saying that we assume everyone is a robot (growing up with 1980’s cinema, this is a very scary concept). One’s happiness and suffering are defined in many different ways. For some, it’s their own happiness and suffering that concerns them. For others, it could the happiness and suffering of their family, country, ethnic group, species, religious organization, humanity in general and/or the entire universe. Most are concerned with all of the above, but with varying degrees and associated weights. In any case, we still assume that the overall goal of each agent is to maximize their happiness and minimize their suffering, regardless of how they define each.

To say this assumption is controversial is an understatement of epic proportions. In fact, behavioral economists counter that such an assumption is unrealistic: people act irrationally all the time. Some sabotage their own happiness or prolong undue suffering due to issues stemming from psychology to social/institutional constructs. Others, such as game theorists like myself, would respond that advanced economic models factoring in such behavioral inconstancies but in the end, agents are still acting rationally.

Here is a personal example. I once volunteered with a nonprofit to help increase the financial literacy and overall occupational wellbeing for those in an extremely economically depressed area. One constant phenomenon was for many to disrupt their chances of success and a better life for seemingly no rational reason. It seemed completely irrational . . . yet a social worker explain it to me perfectly: people who have had little good happen to them always expect the worst; hence, the prospect of good happenings on the horizon is psychologically unsettling. In other words, the chance of increased happiness was causing these individuals increased suffering because they could not handle to possibility of disappointment. Therefore, their actions — while seemingly irrational — were perfectly rational.

Of course, the above is only an anecdotal example. So do not take any real grand notion from it.

Even the awareness of increasing one’s happiness is a fairly new concept to psychologists! Following the works of Freud, Schopenhauer and their derivatives, psychological theory was based upon the notion that the best humans could do was to minimize suffering; any attempt to increase one’s happiness would only lead to more suffering. Classical economic theory also held a similar view toward economic growth. The famed “Dismal Scientist” himself, Thomas Malthus, was of the opinion that any attempt to increase the value and position of an economy would only lead to a more desperate situation due specifically to increases in population growth. Like modern day psychology, economists have largely discredited such theories. The development of positive psychological theory has shown that this may not be the case and that much of our decision-making process is based upon maximizing happiness. Most famous is the PERMA criteria developed largely in part by the research of Martin Seligman: Positive emotion; Engagement; Relationships; Meaning; and, Achievement.

With the assumption of rational agency, we now know that economic agents seek to maximize their happiness and minimize their suffering. Yet “happiness” and “suffering” are not very scientific term. Instead, we tend to employ the terms benefit instead of happiness and cost instead of suffering. And while we can agree that individuals may define what their happiness/benefit consists of, the general question still remains: how do we measure one’s benefits and costs? There are two popular answers: utility and monetary.

Utility is a philosophical/theoretical concept of measuring benefit. Created by Jeremy Bentham and John Mill, the concept of utility was meant to help aid a theoretical discussion on the morality of decision-making. Specifically, a util is a unit of benefit/happiness. Is there an objective and scientific measurement criteria for a util? Of course not, but it still serves a vital purpose. Let’s look at an example: you come home from a day of work and must decide to hug your mother or father first. Suppose you deduce that giving your mother a hug first results in 5 utils of benefit and hugging your father first results in 3 utils of benefit. We may not be able to truly define what a util is in regards to a weighted and comparable value, BUT we do know that 5 utils is greater than 3 utils. Barring any associated costs and/or consideration of your parents’ benefits and costs, one maximizes their benefit by hugging their mother first and father second.

Monetary units —- such as revenues, wages, physical returns on investment, earnings, rents — are, by and large, a more popular measurement because they tend to be quantifiable and quasi-objective. In a way, we use monetary units as a proxy for happiness and the value of the good, service or experience. If one values something highly, they would be willing to sacrifice a larger portion of their constrained budget for it. If not, then one would be less willing to spend a large percentage of their budget on it. As an example, the wage you are offered when you sell your labor to an employing firm is the value that the firm has for it.

One may ask: is this all you got? Theoretical units and dollar signs? True, the entirety of the human experience cannot be quantified by such means alone (although many try), but it seems to be the best (i.e., data-wise) and easiest we have come up with. Admittedly, there is a lot to criticize. If taken too strictly, one could create an economic model populated by agents with a robotic nature towards profit maximization.

This is not only a microeconomic issue. Development economists (again, like myself) and macroeconomists have also struggled with the exclusive use of monetary indicators. For most of its history, development economists have classified the world’s economies according to what is known as Gross National Income per Capita[1]. The GNI per capita, amongst a number of other monetary indicators, is useful but it fails to explain the entirety of an economy’s “experience”. There are many wealthy economies that are accompanied by high levels of unemployment, poverty, poor sanitation and illiteracy. The attachment to such indicators slowly began to become questioned. The famed Dudley Seers once criticized the field for what he called “growth fetishism”; that is, the obsession with defining an economy’s “growth” purely by income statistics. As a result, Seers and others confirmed that to claim economic development, poverty levels, unemployment and inequality had to be shown to have decreased.

Even with the entirety of the criticisms against economics, the field has slowly increased its understanding of all the various factors of that affect human behavior. Amartya Sen, being a development economist, a philosopher and a theorist (and also an academic hero of mine), laid the foundations for what is called the “Capability Approach”. The central idea of Sen’s theory is that monetary style measurements are not the best proxies for happiness and suffering. Besides, there are many wealthy people around the globe who claim to live a life unfulfilled. Therefore, we as economist must be more concerned on enhancing the lives we lead and the freedoms we enjoy than just relying on easily quantifiable measurements.

It works like this: the Capability Approach is made of two factors: functionings and capabilities.

Functionings are what one can possibly do with the resources that he/she has under his/her control; such as personal heterogeneities (i.e., age, gender, disabilities), social capital/climate (i.e., trust, crime, infrastructure), environmental diversities, family distribution and relation perspectives (that is, what is required to maintain a consumption/behavioral pattern). Of course Sen does not only state that these functionings are important in and of themselves, but also the value each individual places upon each of these functionings is just as important. Capabilities are the freedoms and actions one can have given their resources; that is, the ability to convert one’s resources into functions. The two sides do not always match up. The ability of one’s capabilities to meet one’s functionings defines an individual’s happiness. Richard Layard — the creator of “Happiness Economics” — goes further to define happiness as a function purely derived by social capital: family relationships, finances, work, community and friendships, health, personal freedom(s), personal beliefs and values, etc. Yes, we are probably unable to quantify all these factors (can you really put a price of friendships and religious principles?), but this does not mean that people do not value them.

Wait a second? Happiness again? I thought economists try to get away from terms like “happiness”? True, at one time we did. The fact of the matter is that, as the behavioral economists argue (correctly, in my opinion), the field of economics has a history of attempting to make itself a “hard science” a la mathematics and physics. This experiment has by-and-large failed. Now that economists have expanded their mathematical and statistical skills, many modern models are beginning to dig deeper into the way humans make their decisions . . . yet this is all done using theoretical models that employ very complex mathematics.

In the end, what can be said about the rift between behavioral economists and theoretical economists? Even with my biases, I can agree that there is a lot of good in the behavioral economics field and the criticisms of theory . . . there is a lot of bad too. I reiterate here that it is not for me to form an opinion for you, the reader. Behavioral economics is a hot trend right now (yes, even economics is prone to the latest and greatest “sexy” theories) and behavioral economists, like Thaler, have some amazingly worthwhile points. Of course, theorists have come a long way as well. Our initial assumptions on how humans make decisions may have been too strict, but our methods are acute.

[1] The total value of an economy’s production of final goods/services bought and sold, plus the domestic resident incomes from abroad and the subtraction of non-domestic resident incomes made domestically, divided by the total domestic population.